What are some examples of things that are scarce that you encountered this morning?

Does scarcity only exist in industrialized or capitalist societies?

9Chapter 1 Fundamental ConceptsScarcity

If something has a price in a market, does that generally mean that it is scarce?

What sort of things that occur outside of markets are scarce?

Do animals, plants, and other life experience scarcity?

10Chapter 1 Fundamental ConceptsScarcity

Why is choice necessitated by scarcity? By

Individuals

Organizations (groups, NGOs, businesses)

Governments

Animals, plants, other life

11Chapter 1 Fundamental Concepts

Since so many aspects of our world involve choices necessitated by a condition of scarcity, some element of economics is exists in most everything we do, whether we are aware of it (or whether we like it) or not.

12Chapter 1 Fundamental Concepts

Since scarcity forces us to make choices from a set of alternatives, on what basis can we (or do we) rank the various alternatives and choose the best one?

Economics occurs in the context of value systems that guide us in ranking alternatives and in distinguishing good from less good allocations.

While markets are a prominent way of making allocation choices in the context of scarcity, economics encompasses the study of both market and non-market allocation of scarce resources.

As Tom Power observes, economic analysis of the environment is challenging and important precisely because its value is not always conveniently revealed in a market, and thus is subject to inappropriate use.

14Chapter 1 Fundamental ConceptsEconomics vs. Environment-

Can we really put economics all on one side, and environment all on the other side?

Is this simply a convenient way for the media to characterize conflicting values?

If scarcity means that choices must be made, then what are the tradeoffs?

15Chapter 1 Fundamental ConceptsWhat is opportunity cost?

When something scarce is allocated to one particular use, the opportunity cost of that choice is the value of the best alternative given up.

What is an example of an opportunity cost?

Opportunity cost can be easy or very difficult to measure.

16Chapter 1 Production PossibilitiesThe concepts of scarcity and opportunity cost can be illustrated in a production possibilities frontier (PPF). The PPF represents all the possible combinations of food and clothing that can be produced in a given time period when available resources are fully and efficiently employed. 17Chapter 1 Production Possibilities 18Chapter 1 Fundamental ConceptsWhat is economic rationality?

A choice from among competing options is said to be economically rational when it yields anticipated net benefits that exceed the opportunity cost.

In other words, economic rationality as used in this class simply means that we can model the choice environment confronting individuals, businesses, or government. With enough information we can construct economic models to predict choice.

19Chapter 1 Fundamental Concepts What sort of questions and problems are studied in the area of environmental economics?Pollution and externalities causes, consequences, instruments for their control, policy, political economy 20Chapter 1 Fundamental ConceptsWhat sort of questions and problems are studied in the area of natural resources economics?Production, markets, management, uses, and abuses of natural resources such as marine and freshwater fisheries, forests, grazing lands, aquifers, and energy and minerals 21Chapter 1 Fundamental ConceptsWhat sort of questions and problems are studied in the area of ecological economics?

Understanding and restoring stocks of natural capital, from which flow various forms of ecosystem goods and services.

What are some examples of ecosystem goods and services?

22Chapter 1 Fundamental ConceptsWhat are some examples of environmental or natural resource policy success stories? 23Chapter 1 Fundamental ConceptsWhat are some examples of continuing environmental or natural resource problems that need to be resolved? 24Chapter 2 Value Systems Economic SystemsThroughout time and around the globe, individuals and societies have been motivated by widely different value systems, and so have had different answers to the question of what a good way to allocate things might be. As a consequence we have observed many different kinds of economies. 25Chapter 2 Value Systems Economic SystemsSociety is frequently confronted with policy decisions that must be made because of scarcity. Examples include the allocation of budget monies and the management of public land, water, and wildlife. These policy decisions affect both human and nonhuman communities. Because of scarcity, any choice made by policy makers will have an opportunity cost. What are the values that will be used to rank policy alternatives? 26Chapter 2 Value Systems Economic SystemsFrom an economic point of view a decision is good (or economically rational) when it generates net value that exceeds the opportunity cost. Yet different value systems will lead to a different ranking of alternatives and so will provide different answers to the question of which course of action is best. 27Chapter 2 Value Systems Economic SystemsWhen individuals make choices in the context of scarcity they are guided by their own values and preferences, as influenced by their culture, class, status, and many other factors. In order to make public policy decisions that serve the interests of the public, however, the economic aspects of policy-making must somehow embody society's shared values, and/or aggregate individual values and preferences. 28Chapter 2 Value Systems Economic SystemsThis is one reason why it is said that social institutions (formal or informal rule systems that provide the structure for political and economic choices and interactions) embody the shared (or dominant) values of the societies from which they evolve. 29Chapter 2 Value Systems Economic SystemsFundamentals of Ethical Systems Ethics is a branch of philosophy that is concerned with morality and ideal human character (right and wrong, good and bad). Morality refers to a code of conduct that is held to authoritative in matters of right and wrong. 30Chapter 2 Value Systems Economic SystemsFundamentals of Ethical Systems What is the relationship, if any, between ethical systems and economic systems?If economic policy is to serve the public good, then the values that shape how alternatives are ranked must have some basis in ethics. 31Chapter 2 Value Systems Economic SystemsFundamentals of Ethical Systems Ethical systems may describe particular shared values, or provide a method for arriving at an aggregation of individual values and preferences. Different ethical systems lead to different economic choices. We will look at two distinct ethical systems 32Chapter 2 Value Systems Economic SystemsDeontological Ethics What is the core idea of this ethical system?The ethics of standards Deontological ethics develop theories of action based on duty or moral obligation. Under this system, an action is judged by its intrinsic rightness and not by the extent to which it serves as an instrumentality in furthering ones goals or aspirations. 33Chapter 2 Value Systems Economic SystemsDeontological Ethics A duty is a moral obligation that an agent has towards another person, such as the duty not to lie. Etymologically, duties are actions that are due to someone else, such as paying money that one owes to a creditor. In a broader sense, duties are simply actions that are morally mandatory. 34Chapter 2 Value Systems Economic SystemsDeontological Ethics In this tradition, philosophers held the normative theory that moral conduct is that which follows a specific list of duties. These theories are called deontological theories, from the Greek word deon, or duty, since they emphasize foundational duties or obligations. 35Chapter 2 Value Systems Economic SystemsDeontological Ethics We find one of the first clear indications of this view in The Law of War and Peace (1625) by Dutch philosopher Hugo Grotius (1583-1645). For Grotius, our ultimate duties are fixed features of the universe, which even God cannot change, and comprise the chief obligations of natural law. 36Chapter 2 Value Systems Economic SystemsDeontological Ethics German philosopher Immanuel Kant (1724-1804) draws on duty theory both in his early Lectures on Ethics (1780), and also in his later and more systematic ethical writings The Foundations of the Metaphysics of Morals (1785), The Critique of Practical Reason (1788), and The Metaphysics of Morals (1798). 37Chapter 2 Value Systems Economic SystemsDeontological Ethics Kant further refines the notion of duty by arguing that moral actions are ultimately based on a single, "supreme principle of morality" which is objective, rational, and freely chosen the categorical imperative. 38Chapter 2 Value Systems Economic SystemsDeontological Ethics Kant and the categorical imperative "Act as if the maxim of your action were to become through your will a universal law of nature." 39Chapter 2 Value Systems Economic SystemsDeontological Ethics W.D. Ross's The Right and the Good (1930) Duties Fidelity (the duty to keep promises), reparation (the duty to compensate others when we harm them), gratitude (the duty to thank those who help us), justice (the duty to recognize merit), beneficence (the duty to improve the conditions of others), self-improvement (the duty to improve our virtue and intelligence), and nonmalfeasance (the duty to not injure others) 40Chapter 2 Value Systems Economic SystemsDeontological Ethics Are Leopold's Land Ethic and Devall/Sessions/Naess's Deep Ecology within the deontological ethical tradition? Duties?Do some religious systems have features similar to the categorical imperative? 41Chapter 2 Value Systems Economic SystemsDeontological Ethics Are there aspects of deontological ethical ideals expressed in the U.S. Constitution?What happens if members of society cannot agree on the validity and importance of a particular set of duties?Pooling (one big society) Dominant group imposes values on others? Separation Groups form based on shared values 42Chapter 2 Value Systems Economic SystemsTeleological Ethics What is teleological ethics (sometimes known as consequentialism)?The ethics of results This theory states that the moral goodness or badness of an act or rule is determined by the results or consequences of the act or rule. 43Chapter 2 Value Systems Economic SystemsTeleological Ethics Telos is a Greek term for end or purpose. Under teleological systems of ethics, an action is judged not by a categorical imperative to act in a certain way, but by the extent to which the consequences of the action are desirable. 44Chapter 2 Value Systems Economic SystemsTeleological Ethics Acts or rules are ethical or not depending on their consequences or results. No universal ethical standard is applied to acts or rules.British ethical philosophers such as Jeremy Bentham and John Stuart Mill advocated for teleological ethics 45Chapter 2 Value Systems Economic SystemsTeleological Ethics There are three subdivisions of consequentialism 1. Ethical Egoism The moral rightness of an action depends upon how the consequences affect the agent performing the action. 2. Ethical Altruism The moral rightness of an action depends upon how the consequences affect everyone in society except the agent performing the action. 46Chapter 2 Value Systems Economic SystemsTeleological Ethics Three subdivisions of consequentialism, cont 3. Utilitarianism The moral rightness of an action depends upon how the consequences affect everyone in society. This third subdivision of consequentialism, utilitarianism, is most relevant to economic policy, and forms the ethical basis for benefit/cost analysis 47Chapter 2 Value Systems Economic SystemsUtilitarianism In diverse societies where people cannot agree on a universal ethical standard of action based on the categorical imperative, as is required by deontological ethics, results-based utilitarianism offers an alternative that identifies ethical actions or rules by adding up the pleasure or pain of consequences for all members of society. 48Chapter 2 Value Systems Economic SystemsUtilitarianism Jeremy Bentham, a key utilitarian theorist, was dissatisfied with the legal theories of William Blackstone, which served to justify the British legal system. In particular, Bentham thought that the British system of ranking crimes was wrong because it was based on an abstract moral theory rather than on the unhappiness, misery, or disutility a crime caused to other members of society. 49Chapter 2 Value Systems Economic SystemsUtilitarianism Thus in Benthams view the punishments prescribed by law should be proportionate to the disutility created by the crime and not based on notions of intrinsic rightness or morality. Bentham described utility as the principle that approves or disapproves of actions according to their tendency to increase or decrease an individuals pleasure. 50Chapter 2 Value Systems Economic SystemsUtilitarianism Bentham was a hedonist and so believed that pleasure is the only intrinsic good or end against which acts are to be evaluated. As W.H. Auden (1962) observed, pleasure is by no means an infallible critical guide, but it is the least fallible. 51Chapter 2 Value Systems Economic SystemsUtilitarianism How does utilitarianism work?1. Develop a set of alternative policies, including the status-quo (no change). 2. Measure the level of utility or disutility (degree of pleasure or pain) induced on each member of society for each of the alternatives. 52Chapter 2 Value Systems Economic SystemsUtilitarianism How does utilitarianism work, continued3. Add up the utility and disutility for each alternative (note here that "adding up" assumes that different peoples' utility and disutility are commensurable--a notion called cardinal utility). The net utility to all members of society for a given policy alternative is called net social utility. 4. The utilitarian-ethical policy alternative is the one that generates the largest net social utility. 53Illustration 54Chapter 2 Value Systems Economic SystemsUtilitarianism We have identified some problems with deontological ethics. What are some problems with utilitarianism?- How do we measure social utility? relate to ordinal utility- Tyranny of the majority (same failing as democracy) 55Chapter 2 Value Systems Economic SystemsUtilitarianism and Efficiency Utilitarianism also allows for the evaluation of efficiency. What is a good general definition of efficiency?Minimization of waste.There are two different efficiency criteria commonly used by economists for evaluating social policy Pareto and Kaldor-Hicks 56Chapter 2 Value Systems Economic SystemsPareto Efficiency What is Pareto efficiency? Compares policy alternatives to the status quo. To be a Pareto improvement overt the status quo, a new policy alternative must make some people better off (increase their utility), perhaps leave some people unaffected, and make nobody worse off (decrease their utility). 57Pareto Efficiency

In terms of our table several slides ago, policy options B and C both offer a Pareto improvement over the status quo.

If policies B and C cannot be further modified in any way that generates additional Pareto improvements, then both policies B and C are said to be Pareto efficient.

58Chapter 2 Value Systems Economic SystemsPareto Efficiency Is it fair to say that the Pareto efficiency criterion is biased toward maintaining the status quo? This presents ethical problems when the status quo is widely held to be unethical (e.g., slavery). 59Chapter 2 Value Systems Economic SystemsKaldor-Hicks Efficiency What is the Kaldor-Hicks efficiency criterion?Evaluates policy alternatives as well as the status quo. The Kaldor-Hicks efficient policy alternative (which may be the status quo) generates the largest net social utility (or net social benefit), even if some are made worse off. 60Chapter 2 Value Systems Economic SystemsKaldor-Hicks Efficiency The Kaldor-Hicks efficiency criterion is sometimes referred to as being potentially Pareto efficient because the potential exists for those made better off to compensate those made worse off, which would lead to Pareto efficiency by sharing net social benefits with all members of society. 61Kaldor-Hicks Efficiency

Going back to the table, option A generates the largest net social utility, and thus is Kaldor-Hicks efficient.

The problem is that option A makes Edwin worse off relative to the status quo, and thus does not represent a Pareto improvement over the status quo.

62Illustration 63Kaldor-Hicks Efficiency

If option A could be further modified in such a way that Jing and Rose were to jointly transfer at least 20 units of utility to Edwin, then the new modified version of option A would be both Pareto efficient and Kaldor-Hicks efficient.

64Chapter 2 Value Systems Economic SystemsSelf Interest, the Common Good, and Social Order One of the central dilemmas that all societies must confront is how to maintain social order and thus balance the sometimes-conflicting imperatives of self-interest and the common good. 65Chapter 2 Value Systems Economic SystemsSelf Interest, the Common Good, and Social Order What did Hobbes say was the natural order of the human condition in the absence of a common power to keep people in awe? 66Chapter 2 Value Systems Economic SystemsSelf Interest, the Common Good, and Social Order Hobbes Hereby it is manifest that during the time men live without a common power to keep them all in awe, they are in that condition which is called war and such a war as is of every man against every man. Whatsoever therefore is consequent to a time of war, where every man is enemy to every man, the same consequent to the time wherein men live without other security than what their own strength and their own invention shall furnish them withal. In such condition there is no place for industry, because the fruit thereof is uncertain and consequently no culture of the earth no navigation, nor use of the commodities that may be imported by sea no commodious building no instruments of moving and removing such things as require much force no knowledge of the face of the earth no account of time no arts no letters no society and which is worst of all, continual fear, and danger of violent death and the life of man, solitary, poor, nasty, brutish, and short. 67Chapter 2 Value Systems Economic SystemsSelf Interest, the Common Good, and Social Order If we assume for a moment that Hobbs is right, then what is this common power that keeps people in awe and prevents violent and destructive conflict?According to Hobbes, these people will establish fundamental moral laws to preserve peace. This was called the social contract.What are some criticisms of Hobbs view of human interaction? 68Chapter 2 Value Systems Economic SystemsSocial Contract Theory John Locke The natural state (for humans) is a pre-political, yet moral, society where humans are bound by divinely commanded natural law. A social contract is made between citizens who institute a government to prevent people from violating natural law. 69Chapter 2 Value Systems Economic SystemsSocial Contract Theory Jean-Jacques Rousseau The state of nature is not a state of war, but a state of individual freedom where creativity flourishes. Since a fully mature person is a social person, a social contract is established to regulate social interaction. This contract between citizens establishes an absolute democracy which is ruled by the general will, or what is best for all people. 70Chapter 2 Value Systems Economic SystemsSocial Contract Theory John Rawls (A Theory of Justice, 1971) In the original position (heavens waiting room?), a group of rational and impartial people will establish a mutually beneficial principle of justice (including social contract principles) as the foundation for regulating all rights, duties, power, and wealth. 71Chapter 2 Value Systems Economic SystemsSocial Contract Theory Francis Fukuyama The modern liberal state was premised on the notion that in the interests of political peace, government would not take sides among the differing moral claims made by religion and traditional culture. Church and State were to be kept separate there would be pluralism in opinions about the most important moral and ethical questions, concerning the ultimate ends or the nature the good. Tolerance would become the cardinal virtue in place of moral consensus would be a transparent framework of law and institutions that produced political order. Such a political system did not require that people be particularly virtuous they need only be rational and follow the law in their own self-interest 72Chapter 2 Value Systems Economic SystemsThe Social Contract and Social Capital The transparent framework of law and institutions described by Fukuyama must be supplemented by at least a minimum level of social capital. What is social capital, and why is it important here?Social capital refers to the stock of civic virtues and networks of civic engagement, involvement, volunteerism, reciprocity norms, and trust essential to democratic communities. 73Chapter 2 Value Systems Economic SystemsThe Social Contract and Social Capital While social capital seems to be a precondition for economic development and effective government, it tends to be under-provided by private agents. Thus the culture of individualism that is reinforced by the modern liberal state undermines the shared values and the contribution to social capital that creates social order. 74Chapter 2 Value Systems Economic SystemsOrigins of Property Locke Every man has a Property in his own Person. . . . The Labor of his Body, and the Work of his Hands, we may say, are properly his. Whatsoever then he removes out of the State that Nature hath provided, and left it in, he hath mixed his Labor with, and joined to it something that is his own, and thereby makes it his Property. It being by him removed from the common state nature placed it in, hath by this Labor something annexed to it, that excluded the common right of other Men. Yet there are still greatest Tracts of Ground to be found, which (the Inhabitants thereof not having joyned with the rest of Mankind, in the consent of Use of their common Money) lie wasts, and are more than the People, who dwell on it, do, or can make use of, and so still lie in common." 75Chapter 2 Value Systems Economic SystemsOrigins of Property How do Lockes statements on the necessary conditions for establishing a property right to land relate to the U.S. experience with Native Americans and homesteading? 76Chapter 2 Value Systems Economic SystemsOrigins and Consequences of Property What was Rousseau's view of the origin and the effect of private property?Skills and leisure time ? Tools and other conveniencesFarmers use tools to increase ag. output to feed artisansArtisans need food ?Rousseau The division of land necessarily followed from its cultivation, and once property had been recognized it gave rise to the first rules of justice.... It is work alone that gives a farmer title to the produce of the land he has tilled, and consequently to the land itself. 77Chapter 2 Value Systems Economic SystemsOrigins and Consequences of Property Rousseau The division of land had produced a new kind of right the right of property.Natural inequality in skills, motivation, etc. become heightened by inequalities of exchangeStatus became a function of property, which people are unhappy to lose, but not happy to have. The fall from the grace of a pre-property golden age. 78Chapter 2 Value Systems Economic SystemsOrigins and Consequences of Property Rousseau To the poet it is gold and silver, but to the philosopher it is iron and grain that made men civilized and brought on the downfall of the human race.Freedom was lost as people became slaves to the social demands for property, leading to competition and rivalry on the one hand, opposition of interests on the other, and always the hidden desire to profit at the expense of others. All these evils were the first effect of propertyWhat do you think? 79Chapter 2 Value Systems Economic SystemsPositive v. Normative Economics What is positive economics?Explains what is using best methods. Peer review. Evolutionary process by which as hypotheses are maintained rather than rejected over time they come closer and closer to fact. Attempts to be scientific and objective.In what ways do scientists, the scientific community, and society introduce their values into so-called objective science? 80Chapter 2 Value Systems Economic SystemsPositive v. Normative Economics What is normative economics?Argues for what should be in terms of social policy. Ex we should raise taxes on the rich to fund services for the poor or we should cut business taxes to encourage firms to create jobs. Disputation naturally and necessarily arises.Normative economics is the arena for advocating ones values. 81Chapter 2 Value Systems Economic SystemsThe Three Economic Questions What are the three economic questions that all economies must answer, regardless of value system?1. What to produce with our resources (land, labor, capital, entrepreneurship).2. How to produce what we have decided to produce.3. For whom are we producing (who gets the stuff)? 82Chapter 3 The Economics of Market AllocationLearning objectivesUnderstand the conditions that are required for the existence of a well-functioning competitive marketLearn about the concepts of equilibrium and efficient resource allocationUnderstand the different types of market failure, and the types of interventions that may enhance efficiency 83Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewWhat is the economic definition of capitalism?Resources (land, labor, capital) are privately owned, and production and exchange occurs by way of decentralized markets. 84Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewWhat does it mean to say that there is separation of ownership and control in a modern corporation?

Publicly traded ownership shares make it much easier for firms to raise money from investors (why?)

Shareholders own the corporation, but management runs the company (subj. to board oversight)

85Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewHow are the three economic questions answered in a capitalist system?

What to produce driven by consumer demand

How to produce driven by incentive of profit maximizers to minimize cost.

For whom to produce driven by willingness-to-pay

86Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewWhat are the origins of capitalism?

Motivation for trade (spices, silk, jewels, etc) ?

Need for physical capital (ships, mules, inventory, )

People with talent to be traders (entrepreneurs) usually lacked money to buy capital ?

Development of banks, insurance, etc 87Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewCurrent concerns?

Corporate power, ethics, influence, and accountability

Can a national government have sovereignty over modern transnationals?

International trade and investment treaties may provide inadequate labor and environ. protection

88Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewCurrent concerns, continued

Large corporations may partner with undemocratic governments on projects that exploit the unempowered

Other?

89Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewThe corporate structure is so prevalent in part because it is very effective at raising funds from small investors and limiting liability 90Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewWhat did Adam Smith mean by the concept of the invisible hand of the market?Remarkable outcome that efficient system-wide resource allocation can result from the interaction of self-interested parties in markets, rather than the visible hand of a central planner 91Chapter 3 The Economics of Market AllocationCapitalism A Brief OverviewSuppose that we wanted to replace decentralized market allocation with central planning. How much information would the planner need in order to know what to produce, how much, how to produce, etc?Hayek Billions of bits of information are integrated in market exchanges. 92Chapter 3 The Economics of Market AllocationAssertion A well-functioning competitive market in equilibrium is efficientLets work through each part of this assertion 93Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientWhat is required in order to have a well-functioning competitive market?

Well-defined and enforceable property rights that determine ownership and the right to sell

A market institution that sets prices and facilitates trades at low transaction costs

Large numbers of buyers and sellers, each small in size relative to the overall market, and thus lacking the market power to individually manipulate market price.

94Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientWhat is required in order to have a well-functioning competitive market, continued

There are no significant positive or negative externalities (to be discussed in Chapter 4)

Buyers and sellers cannot collude

There is potential for low-cost entry and exit by potential buyers and sellers

Information on price, quality, availability, etc is low cost

95Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientWhen one or more of these conditions fail to hold in an important way, the result is called market failure, which we will discuss later 96Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientNow lets explore the concept of a well-functioning competitive market being in equilibriumDemand What are the various factors that influence the quantity of a particular good or service demanded by consumers in a market? 97Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientQuantity demanded (QD) function of

Using statistical techniques called econometrics, one can quantitatively estimate a demand function (not required for this class)

This allows economists to focus on key cause-effect relationships

The most important cause-effect relationship is between price and quantity demanded

100Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientDemand Curve Graphical illustration of a demand schedule, which indicates the relationship between price (y variable) and quantity demanded (x variable), holding all other demand factors constant.Law of Demand Inverse relationship between price and quantity demanded. Why? 101Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientIndividual consumer demand reflects willingness-to-pay, a combination of (i) preferences and (ii) ability to pay. Lets consider the derivation of an individual demand curve. 102Chapter 3 The Economics of Market AllocationConsider the following marginal utility data for a simplified consumer choice problem 103Chapter 3 The Economics of Market AllocationIf each lunch alternative below costs 4 and if our consumer has a budget of 24 per week to fully spend on lunches, how many of each will she buy in order to maximize her total utility? Use marginal analysis to shop for the largest available marginal utility with each 4 expenditure. You identify these choices by dividing the marginal utility values in the preceding table by each items price, which gives you marginal utility per dollar spent. Then shop for the largest marginal utility per dollar spent (biggest bang for the buck). 104Chapter 3 The Economics of Market AllocationCalculate Marginal Utility per Dollar Spent for Each Option 105Chapter 3 The Economics of Market AllocationOur consumers weekly lunch choice will start with buying a sub, followed by another sub. This will continue until she has successively bought 4 subs and 2 burritos for her weekly lunches. This fully expends her 24 weekly lunch budget, and generates 146 units of total utility. Can you spend 24 given her marginal utility data and get more total utility? 106Chapter 3 The Economics of Market AllocationNow lets do a comparative-static experiment and reduce the price of burritos to 2. Ceteris paribus, how will this affect our consumers utility-maximizing weekly lunch choices? Now our hungry consumer will maximize her total weekly utility by consuming six burritos and three subs each week. 107Chapter 3 The Economics of Market AllocationCalculate Marginal Utility per Dollar Spent for Each Option 108Chapter 3 The Economics of Market AllocationNow we can derive our consumers demand curve for burritos, since we have two price observations (4 and 2) and two quantity demanded observations (2 and 6). 109Chapter 3 The Economics of Market Allocation 110Chapter 3 The Economics of Market AllocationThere are many consumers buying burritos in this city. If at a price of 4 we added up the quantity demanded by all burrito consumers in the city, we would get one point on the MARKET demand curve for burritos in the city. Do the same at a price of 2. You can then draw the market demand curve. This process is called horizontal summation (adding up individual quantities demanded at each price horizontal, since quantity is on the horizontal or x axis). 111Chapter 3 The Economics of Market AllocationNote If a factor other than price changes (such as perceived quality, number of buyers, price of substitutes or complements, etc), the demand curve itself will shift out (increase in demand) or in (decrease in demand) 112Chapter 3 The Economics of Market AllocationExample Increase in demand for firewood when the price of natural gas doubles 113Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientSupply What are the various factors that explain the quantity of a good or service supplied by sellers in a market? 114Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientQuantity supplied (QS) function of

the price of the good

production costs

price of production substitutes (e.g., corn v. wheat prices for a farmer capable of growing either

Marginal cost (MC) increase in total cost caused by a small increase in output.

Marginal product of labor additional output added by an additional unit of labor.

Marginal revenue (MR) increase or decrease in total revenue caused by a small increase in output. In a competitive market, MR is equal to market price P.

117Chapter 3 The Economics of Market Allocation

Defining terms, continued

Economic short run Time period in which capital is fixed.

Law of Diminishing Marginal Returns In the short run as more and more of a variable input is added to a fixed input, congestion occurs and the marginal productivity of the variable input eventually declines.

118Chapter 3 The Economics of Market AllocationWe will now derive a competitive firms supply curve from its marginal cost curve. We will do so using a restaurant example. The following tables show hypothetical information 119Chapter 3 The Economics of Market Allocation 120Chapter 3 The Economics of Market AllocationThe preceding table demonstrates something called the Law of Diminishing Marginal Returns. In the economic short run, where capital is fixed, then as you use more and more of a variable factor with the fixed factor, the marginal productivity of the variable factor will eventually decline. This is because the variable factor (e.g., of chefs) experiences congestion due to the capacity constraint of the fixed factor (e.g., the size of the kitchen). 121Chapter 3 The Economics of Market Allocation 122Chapter 3 The Economics of Market AllocationIn the preceding slide we see that the profit-maximizing quantity of food to produce (and number of restaurant employees to hire) occurs where marginal cost equals marginal revenue. This is indicated in bold font in the preceding slide. 123Chapter 3 The Economics of Market AllocationLets see how the profit-maximizing quantity of food to produce by the restaurant changes if the menu price of the food increases. What do you think will happen? Why? 124Chapter 3 The Economics of Market Allocation 125Chapter 3 The Economics of Market AllocationAs price rises, the restaurant can justify hiring more workers and produce a larger quantity of meals. In order to produce more in the short run, price must rise in order to induce the firm to justify paying a higher marginal cost.As price rises, the firm increases output by setting P MC. What do we call a curve that explains the relationship between price and quantity supplied? 126Chapter 3 The Economics of Market Allocation 127Chapter 3 The Economics of Market AllocationAs with demand, one can horizontally sum quantities supplied at each market price in order to get the market supply curve. Now lets put market supply and demand together. 128Chapter 3 The Economics of Market Allocation 129Chapter 3 The Economics of Market AllocationMarket equilibrium The Law of One Price there is one price where QS QD. There is no excess supply or excess demand. Occurs at the intersection of the supply and the demand curves.Efficient resource allocation When we say that a well-functioning competitive market in equilibrium is efficient, we mean that we cannot increase or decrease quantity produced and improve the total gains from trade (or welfare) of the market participants. 130Chapter 3 The Economics of Market AllocationConsumer Surplus Like getting a bargain, consumer surplus measures the gains from voluntary trade that flow to consumers. It is measured by the difference between the demand curve and price, up to quantity purchased.Producer Surplus Like profit (except leaving out fixed cost), producer surplus measures the gains from voluntary trade that flow to producers (firms). It is measured by the difference between price and the supply curve, up to the quantity sold. 131Chapter 3 The Economics of Market Allocation 132Chapter 3 The Economics of Market Allocation 133Chapter 3 The Economics of Market AllocationA well-functioning competitive market in equilibrium is efficientThe equilibrium is efficient because the total gains from trade are as large as possible.At any other price there is excess supply or demand, and the total gains from trade are smallerRelative to the status quo of no exchange, the competitive market equilibrium is Pareto efficient. Why? 134Chapter 3 The Economics of Market AllocationPrice above equilibrium ? (CS PS) smaller, thus inefficient 135Chapter 3 The Economics of Market AllocationPrice below equilibrium ? (CS PS) smaller, thus inefficient 136Chapter 3 The Economics of Market AllocationMarket FailuresA market failure occurs when one or more of the requirements for a well-functioning competitive market fails to hold in a significant way1. Monopolies, cartels, and market power ? firms are able to withhold quantity from the market to raise price, which results in inefficiency.Intervention Antitrust and regulation policy 137Chapter 3 The Economics of Market AllocationMarket Failures2. Externalities (positive or negative to be discussed in Chapter 4)Prices and quantities distorted in the market ? inefficiency. Government interventions Wait till next chapter ? 138Chapter 3 The Economics of Market AllocationMarket Failures3. Collectively Consumed GoodsCommon-pool resources (CPRs) are accessed by multiple people, and feature subtractability (what is used by one is not available to another). Self-interested market allocation can result in tragedy of the commons outcomes. More in Chapter 5. 139Chapter 3 The Economics of Market AllocationMarket Failures4. Imperfect information on quality, safety, etcToo much or too little is produced and consumed, depending on whether quality/safety is over or understated, leading to inefficiency. Intervention (1) provide labeling information. (2) set minimum standards 140Chapter 3 The Economics of Market AllocationMarket Failures5. InequityDoes not imply inefficiency, because most all markets, even those that are highly efficient, feature inequities. Recall Rousseau. Interventions Redistribution through tax and government programs subsidized education, etc. 141Chapter 3 The Economics of Market AllocationGovernment FailuresAs we will learn in much more detail in Chapter 8, government interventions also suffer inefficiencies. Alas!, efficiency-enhancing policies may not be politically feasible, and those policies that are politically feasible may lead to substantial inefficiencies 142Chapter 3 The Economics of Market AllocationPractice Problem

Supply P 100 0.1Q

Demand P 1000 0.05Q

Plot equations on a fully labeled diagram

Solve for equilibrium P and Q

Compute CS, PS, and total surplus

Can Q and P be rearranged in a way that would increase total surplus?

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